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Value Perspective Quarterly Letter - 4Q 2014

31/12/2014

The Value Perspective team

A seasonal tradition as familiar as a carafe of Chateau le Plonk at the Global Value Investing team’s Christmas dinner has begun in earnest: the annual round of stockmarket predictions. We had made some predictions at the event last year, for a bit of fun of course, on where the FTSE 100 would be by the end of 2014. Did anyone guess correctly? Well, it wouldn’t have mattered if we did.

Predictions are useless. In fact, the only predicable thing about them is that most will be wrong – and those that do get lucky are seldom able to repeat their good fortune. Multiple studies have shown that economists and pundits predictions are no better than tossing a coin. Moreover, availability bias means that forecasters usually stick too closely to the prevailing norms, and on those rare occasions when they call for change they often underestimate the potential magnitude. We are constantly reminded of the folly of forecasting. Oil declines more than expected but inflation is lower; new regulation is imposed out of the blue whilst events that appeared certain never come to fruition.

Despite overwhelming evidence against the veracity of predictions, humans are hard-wired to follow them. We seek cause and effect in random patterns and extrapolate them into the future, but we are doomed to fail because the future is not a fixed outcome; it is a range of possibilities. Another closely linked behavioural bias is the most recent outcomes carry the most weight when making future decisions, irrespective of their probability. This is why investors do silly things as bubbles grow and irrational exuberance prevails.

It is therefore imperative to eliminate all emotion from investment; if it feels good it probably isn’t. But not knowing what the future will bring does not mean that we cannot prepare for it. Instead of relying on subjective forecasts, we base our investment decisions on long-term historical data and robust processes in order to determine instances where the upside potential exceeds the downside risk.

First and foremost, stocks must trade at a large discount of fair value. More than a century’s data shows that value investing outperforms on average and over time. Assuming a stock is sufficiently cheap, we then spend a lot of time studying accounts to give us a clear picture of how a company performs across the business cycle. To what extent is a profit recovery within the company’s own control or dependent on external conditions, and what are the major risks associated with it? Finally, we look closely at balance sheets to ensure companies have sufficient capital strength to see them through short and medium-term challenges; a robust balance sheet provides a ‘margin of safety’ against unknowable risks.

Were we to choose to ignore these principles and do something different each time – like clinging to the latest economic forecast – then we would just be individuals doing whatever took our fancy. That is not repeatable. What separates the Benjamin Grahams of this world from the average fund manager is an investment process that is repeatable, process-driven and based on history. That is value investing – and only by being disciplined and consistent can we deliver its long-term performance advantage.

History suggests that the resulting outperformance of the portfolio from today’s level should be significant on a 10 year view, but performance is always lumpy and it is not possible to predict when sentiment will wax or wane for our investments.

Our predictions on the FTSE 100 level by the end of 2015? We have no idea, which is why we do not invest as if we do.

The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.